U.S. District Court Signals That In Certain Cases, NFTs May Qualify as Securities

Alerts / March 3, 2023
Key Takeaways
  • The United States District Court for the Southern District of New York recently confirmed for the first time that under certain circumstances, nonfungible tokens (NFTs) may qualify as securities under the Securities Act of 1933 (Securities Act), and that crypto assets (nonfungible or otherwise) may also qualify as securities regardless of whether they were offered under an “initial coin offering” (ICO).
  • In the decision, the District Court denied defendants’ motion to dismiss a class action complaint that alleged the offer and sale of basketball-themed NFTs (referred to as “Moments”), which resided on a decentralized “private” blockchain and were available only through a centralized platform, qualified as “investment contracts” under the standard set forth by the U.S. Supreme Court in SEC v. W.J. Howey Co. (Howey).
  • In issuing its holding, the District Court found “fundamental” plaintiffs’ assertion that defendants’ maintenance of a private blockchain was required in order to support the sale and ongoing trading of Moments.

Dapper Labs was founded in 2018 shortly after the debut of its first NFT collection, “CryptoKitties,” [1] which was so successful it created a bottleneck of transactions on the decentralized Ethereum Network. Seeking faster transaction throughput, Dapper Labs later launched its own decentralized “Flow Blockchain” and native FLOW token. In 2019, Dapper Labs launched the NBA Top Shots (Top Shots) platform on the Flow Blockchain as a joint venture between itself, the National Basketball Association (NBA), and the National Basketball Players Association.  Dapper Labs then announced the creation of Moments – NFTs individually marked with unique identifiers that refer to video clip highlights of basketball games. Moments can be acquired through “packs” sold directly by Dapper Labs on the Top Shots platform, or individually through secondary sales on the marketplace.

In May 2021, class action plaintiffs sued Dapper Labs and its chief executive officer in New York State Court. The complaint alleged that Dapper Labs used its control over the Top Shots platform and Flow Blockchain to prop up Moments’ value, citing to, among other things, certain plaintiffs’ inability to withdraw funds from the platform for up to months at a time. Relying on these and other facts, plaintiffs’ complaint alleged Dapper Labs violated Sections 5 and 12(a)(1) of the Securities Act through its unregistered offer and sale of Moments. Section 12(a)(1) provides a private right of action against issuers of securities for failure to comply with the registration and prospectus requirements of Section 5. In July 2021, Dapper Labs removed the action to the U.S. District Court for the Southern District of New York and then moved to dismiss the complaint.

On February 22, 2023, relying on the “investment contract” analysis in Howey, the Court denied defendants’ motion to dismiss, holding that plaintiffs plausibly alleged that Moments could qualify as securities because the complaint pleaded (1) an investment of money (2) in a common enterprise (3) with the expectation of profit from the entrepreneurial or managerial efforts of others.[2]

FLOW, the Flow Blockchain, and Moments

The Court rejected defendants’ argument that plaintiff’s allegations about the FLOW token and blockchain were irrelevant, instead finding that its analysis would necessarily incorporate the “totality of the scheme at issue,” including allegations about Dapper Labs’ control of FLOW, the Flow Blockchain, and Moments.[3] The Court also considered plaintiffs’ description of the Flow Blockchain as “private” and reasoned that because FLOW’s utility created value for Moments through “the Flow Network’s consensus as to ownership and the price of each transaction,”[4] such facts as pleaded by plaintiffs were relevant and critical to supporting their allegations that Moments were offered as investment contracts pursuant to Howey.[5]

The Howey Test

Finding the first prong of Howey not in dispute, the Court used the bulk of its opinion to explain its decision that plaintiffs adequately pleaded the other two prongs of the test.

Common Enterprise

Rejecting defendants’ position that the Second Circuit relies exclusively on the application of the “horizontal commonality” test to determine whether a common enterprise existed, the Court confirmed its practice of applying both the “horizontal commonality” and “strict vertical commonality” tests.

The Court addressed horizontal commonality first, and stated that in order to plead it, plaintiffs must show (i) “a sharing or pooling of the funds of investors” and (ii) “that the fortunes of each investor in a pool of investors are tied to one another and to the success of the overall venture.”[6] With regard to the pooling of funds, the Court rejected defendants’ assertion that “the offering and the capital pooled therefrom” must “occur in advance of the construction of the ecosystem that supports, and which increases, the value of the token.” The Court explained that a temporal requirement is “not supported by the case law and does not follow from a practical perspective” because it would “inappropriately limit the scope of investment contracts to pre-development initial offerings.”[7] Instead the Court found that plaintiffs successfully pleaded that Dapper Labs pooled investor funds by alleging that Dapper Labs received revenue through sales of Moments and charged fees on secondary sales on the platform, which were used to support the growth of the Flow Blockchain; purchaser’s funds were held in Dapper Labs-controlled wallets; and Dapper Labs restricted customers’ ability to withdraw funds during certain time periods.  The Court concluded that pooling “occurs when the funds received by the promoter through an offering are, essentially, reinvested by the promoter into the business.”

The Court also found unavailing defendants’ argument that plaintiffs failed to show that their fortunes were tied to other Moments owners and the success of the overall venture. Instead, the Court held that plaintiffs “adequately alleged that the value of Moments is causally related to the profitability of [Dapper Labs] as a whole because their value depends on the success of the Flow Blockchain.”[8] In support of its holding, the Court pointed to plaintiffs’ assertion that Moments can only be traded on defendants’ proprietary Top Shot platform and referenced an article presented by plaintiffs that reported the steep decline of Moments’ value during a period in which the trading of Moments was halted. The Court also found persuasive the Top Shot Terms of Use, which state, “Moments have no intrinsic or inherent value outside of the Flow Blockchain”[9] and the fact that plaintiffs own nothing except the “line of code recorded on the Flow Blockchain, as no other rights to use or display the image are transferred.”[10] Accordingly, the Court reasoned that if Dapper Labs went out of business, Moments would have no value, unlike rare collectibles.

As to the strict vertical commonality test, the Court agreed with defendants that plaintiffs’ sole allegation that Dapper Labs’ collection of a 5% fee on every transaction in the Marketplace was insufficient to satisfy the test, which requires that “the fortunes of plaintiff and defendants are linked so that they rise and fall together.” The Court held that while the transaction fees were “potentially probative” in determining the issue, the fees are not dispositive, as the fees were collected irrespective of the success of Moments on the Marketplace. The Court also rejected plaintiffs’ argument that the value of Moments and FLOW tokens are inextricably connected, reasoning that the launch of new Dapper Labs projects could increase the price of FLOW tokens but decrease the value of Moments, further demonstrating plaintiffs’ failure to show their fortunes were linked to defendants’ so that they would rise and fall together.

Expectation of Profits Based on the Managerial Efforts of Others

As to the final Howey prong and whether the purchasers had an expectation of profits, the Court stated that defendants’ argument that plaintiffs were required to show a “persistent” promise of profits had “no support in the Second Circuit.” The Court instead found that Dapper Labs’ public statements and marketing materials, such as tweets promoting high-value Moments -- replete with “rocket ship” and “money bag” emojis, as well as evidence of investors describing Moments as investments -- sufficient to imply the likelihood and expectation of profits. The Court also relied on the Terms of Use restrictions on purchasers’ use of Moments to support its finding that plaintiffs adequately pleaded an expectation of profits, because the restrictions, which limited sharing the Moments on social media under certain conditions and restricted purchasers from modifying the Moments, limited their use as collectibles.

As to whether purchasers’ expectation of profits was based on the managerial or entrepreneurial efforts of others, the Court held that irrespective of market forces that may impact Moments’ value, purchasers relied on defendants’ efforts to maintain Moments’ value because their viability as a digital asset relies significantly on the Flow Blockchain, FLOW token and the Top Shots platform. Unpersuaded by defendants’ assertion that Dapper Labs’ role in the creation and promotion of Moments was not managerial, the Court held that plaintiffs plausibly alleged that “[w]ithout Dapper Labs’s continued maintenance of the Flow Blockchain and the ‘token that powers it all,’ FLOW . . . Moments would have no value”[11] and that “[d]efendants’ failure to acknowledge the blockchain technology that underlies Moments is fatal to their Motion in this respect.”[12]


The Court concluded by stating that its decision was a narrow one and “[n]ot all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.”[13] The privatization of the Flow Blockchain under Dapper Labs’ control was a fundamental factor in reaching its decision. Specifically, the Court stated that “[t]he privatization and restrictions that Dapper Labs implements are what distinguish Moments from cardboard basketball cards, which can be freely alienated to whomever and over whatever platform the owner prefers”[14] The Court’s denial of the motion to dismiss is not a final determination on the merits; rather, the Court ruled on whether the allegations, if accepted as true, are sufficient to warrant that the case be permitted to proceed to discovery. Unless the case settles, the Court will have the opportunity to decide whether Moments are securities and if their offer and sale violated federal securities laws.

The BakerHostetler Blockchain Technologies and Digital Currencies team and the White Collar, Investigations, and Securities Enforcement and Litigation team are composed of dozens of experienced individuals, including attorneys who have served in the Department of Justice and the Securities and Exchange Commission (SEC). Our attorneys include former U.S. attorneys, branch chiefs and unit chiefs as well as partners who have served in the SEC’s Division of Enforcement and the SEC’s Office of the General Counsel, and attorneys with extensive experience across all sectors of the blockchain and cryptocurrency markets, including investigations, Bank Secrecy Act and anti-money laundering compliance, tax, privacy, transactions, intellectual property, and technology design. Please feel free to contact any of our experienced professionals if you have questions about this alert.

[1] CryptoKitties were co-launched by Axion Labs in late 2017. Mason Marcobello, CryptoPunks, CryptoCats and CryptoKitties: How They Started and How They’re Going, CoinDesk (Aug. 19, 2022),

[2] Friel v. Dapper Labs, Inc., et al., No. 1:21-cv-05837, —F.Supp. 3d—, 2023 WL 2162747, at *7-8 (S.D.N.Y. Feb. 22, 2023) (citing S.E.C. v. Howey Co., 328 U.S. 293 (1946)).

[3] Id. at *9.

[4] Id.

[5] Id.

[6] Id. at *10.

[7] Id. at *11.

[8] Id. at *12 (internal citations and quotation marks omitted).

[9] Id. at*13 (citations omitted).

[10] Id.

[11] Id. at *19.

[12] Id.

[13] Id. at *22 (citations omitted).

[14] Id.

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